How new guidelines on ESG risks for European banks reduce regulatory complexity
Amid ongoing discussions about alleviating the regulatory burden for firms in the climate and environmental transition, the practical approach to supporting coherence seen in the European Banking Authority’s new Guidelines on the management of ESG risks is an example to follow, writes Agnieszka Smoleńska.
Firms are making use of transition plans to outline how they intend to adjust their strategies in the light of climate and environmental challenges. In just a few years they have transformed from voluntary disclosure frameworks backing up firms’ ‘net zero’ pledges into a regulatory phenomenon drawing the interest of public authorities, investors, business partners and civil society globally (e.g. the UK’s erstwhile Transition Plan Taskforce).
Growth in regulatory complexity around transition planning
A particularly complex regulatory framework has emerged in the EU, where no fewer than three different sets of transition plan requirements are scattered across rules applying to financial and non-financial firms. 2022’s Corporate Sustainability Reporting Directive (CSRD) requires that firms disclose information on how they intend to ensure their business model is compatible with limiting global warming to 1.5°C in line with the Paris Agreement. 2024’s Corporate Sustainability Due Diligence Directive (CSDDD) goes one step further, requiring large companies to adopt and put into effect a climate change mitigation plan. For the banking sector, the Capital Requirements Directive (CRD6), also released in 2024, asks credit institutions to develop ‘specific plans’ to manage short-, medium- and long-term risks arising in the context of the process of adjustment to transition.
Each of these three sets of transition plan requirements have different regulatory objectives in mind (investor protection, corporate governance and risk management, respectively) and also different institutional and substantive scopes as well as timelines. This has led to an increase in calls for the reduction of regulatory burdens.
In the recently published Guidelines on the management of ESG risks, the European Banking Authority (EBA) develops consistent interpretations of scattered requirements, closes regulatory gaps, and maintains a high level of ambition for the integration of environmental, social and governance (ESG) risks in the prudential supervision of banks, in particular regarding bank transition plan requirements. The Guidelines show how complexity can be reduced without compromising public policy goals: these clear guidelines speak to the specific use case of risk management, while maintaining consistency with other parts of the regulatory puzzle.
Goals of the EBA Guidelines
The EBA Guidelines clarify regulatory requirements regarding the identification and management of ESG risks as part of the EU’s overall microprudential regulatory framework for banks. They are intended to support supervisors across the EU in enforcing regulatory requirements and will apply to large banks in the EU from 2026.
The Guidelines have three goals: to set minimum standards and reference methodologies for the identification, measurement, management and monitoring of climate and environmental risks (as well as ESG risks more broadly), to develop qualitative and quantitative criteria for the assessment of such risks’ impact on bank risk profile and solvency across different time horizons, and to outline the content of transition plans serving prudential uses (see art. 87a(1) and 74 Capital Requirements Directive/CRD6). In addition, they solidify the foundations of the EU’s approach to ESG risk management, namely the definition of sustainability transition policy objectives (e.g. climate neutrality, biodiversity loss prevention) and the extension of related prudential assessments’ time horizons from two to five years to 10 years.
Reducing regulatory complexity through technical rulemaking
The EBA Guidelines support regulatory consistency and close off regulatory gaps in four ways, outlined below.
First, the Guidelines prioritise consistency across the different pieces of the sustainable finance regulatory framework, while developing the distinct prudential use case for transition plans. The EBA clarifies how banks should use data inputs, assessments and outputs from other pieces of the regulatory puzzle. The Guidelines suggests how banks should use the mandatory disclosure requirements (e.g. on firm reporting and materiality methodologies under the CSRD), Pillar 3 information on ESG risks already disclosed by banks (e.g. regarding sectoral approaches) and other regulatory requirements (e.g. EBA Guidelines on Loan Origination). This approach supports consistent treatment of real economy firms by banks as the latter develop further data collection and client engagement practices.
At the same time, the EBA develops the distinction between those aspects of bank transition planning that are internal (e.g. internal organisation, lines of defence, specific procedures) and those that are externally-facing (e.g. disclosures, communications, pledges). The prudential aspects of bank transition planning should be anchored in bank business models, including risk and funding strategies, appropriate setting of risk appetite, and internal capital adequacy assessments. However, any pledges or disclosures that banks make, should be consistent with what happens inside the bank, as the alternative exposes banks to litigation and reputational risk. This distinction makes clear that prudential rules do not (or rather at this point cannot) require banks to adopt sustainable business models as long as banks make adequate provision for possible climate and environmental risk impacts.
Second, the EBA draws on the existing global transition plan frameworks in the Guidelines to the extent that is possible. For example, the proposed aspects of transition plans (i.e. strategic objectives; target and metrics; governance; implementation strategy; engagement strategy) mirror the existing global frameworks developed by the Global Financial Alliance for Net Zero and Transition Plan Taskforce. This approach facilitates comparability and convergence also with regard to banks’ operations in third countries and supports interoperability with other jurisdictions developing bespoke approaches to financial institutions’ transition plans (e.g. Singapore).
Third, the EBA develops detailed regulatory guidance with regard to areas that have been indicated as particularly problematic by banks. For example, in terms of data availability concerns, the Guidelines cover various aspects of data management, including the collection, validation and aggregation of data. The EBA develops principles for how the collection of data relevant for climate and environmental risk assessments should be anchored in wider bank data governance and IT infrastructure, integrated with other regulatory requirements (e.g. CSRD ‘data points’ collection) and involve banks’ own assessments of adequacy of external data sources (such as proxies and third-party data providers). A non-exhaustive list of key data points supports the prioritisation of relevant metrics by banks (e.g. geographical location, fossil fuel dependency, energy efficiency levels). Acknowledging the teething problems related to data availability, the Guidelines require an analysis of the implications of data gaps and support a sequential approach, accepting a best-effort approach that develops over time.
Fourth, the Guidelines support a progressive extension towards other environmental risks, while acknowledging that the development of metrics and methodologies is at an earlier stage than for climate-related financial risks. The differentiated approach extends to the aspects of addressing ESG risks covered by the guide: risk identification and management as well as transition planning. At the same time, the EBA clarifies the common foundation, namely a materiality assessment approach that encompasses financial and environmental materiality, where the latter covers situations where the activities of banks’ counterparties could have an impact on the bank via reputational, litigation or business model risks. Both channels of materiality impact can drive financial risk and as such need to be adequately managed by banks as a matter of risk governance.
Limits to the EBA’s approach
The EBA Guidelines seek to strengthen the resilience of banks to C&E risks where these risks have not yet been adequately addressed and as such may give rise to systemic instability risks and lead to related costs for the public. The EBA’s approach shows how regulatory complexity may be reduced through a pragmatic approach that focuses on interoperability, sequential enforcement, consistent data use and convergence between externally and internally facing processes.
This narrow prudential approach, however, cannot be developed in isolation from other regulatory interventions that support the sustainability transition of the real economy, including rules requiring that firms’ business models align with planetary boundaries. Here the Guidelines reveal the limits to the ‘convergence-through-technical-rulemaking’ approach, where financial authorities cannot require that banks align their business practices with net zero, and any guidance on the latter must necessarily involve other public authorities that enjoy broader mandates.